Did financial illiteracy contribute to subprime crisis?

It makes intuitive sense that complicated mortgage products would pose the most danger the borrowers who were least able to understand them. But did that intuition bear out in the real world? Sadly, yes. According to a new paper by Kristopher Gerardi, Lorenz Goette and Stephan Meier, "foreclosure starts are approximately two-thirds lower in the group with the highest measured level of numerical ability compared with the group with the lowest measured level. The result is robust to controlling for a broad set of sociodemographic variables and not driven by other aspects of cognitive ability or the characteristics of the mortgage contracts."

To translate that back into English, borrowers with the most financial literacy were two-thirds less likely to be in foreclosure than borrowers with the least financial literacy. That result remained even after controlling for demographic characteristics such as education and income and the specific mortgages both groups signed. Bottom line: "Twenty percent of the borrowers in the bottom quartile of our financial literacy index have experienced foreclosure, compared to only 5 percent of those in the top quartile. Furthermore, borrowers in the bottom quartile of the index are behind on their mortgage payments 25 percent of the time, while those in the top quartile are behind approximately 10 percent of the time."

What seems to be happening here is not that folks who are financially illiterate choose worse mortgages so much as folks who are financially illiterate make more financial mistakes once they have their mortgages. Either way, it's a reminder of the extraordinary asymmetry of information that stands between borrowers and lenders. You can download the full paper here (pdf).

What also seemed to be happening, here in the Bay Area and in some other parts of the country, was that unscrupulous mortgage brokers deliberately peddled the most toxic products to the people who understood them the least.

Elderly African-Americans for example who owned their homes free and clear were preyed upon by door-to-door salesmen who encourtaged them to tap the equity in their homes to raise their standard of living. They did not appreciate the consequences and in some cases lost their houses and were evicted just as their health began failing. Their children lost any poassible inheritance or ability to care for their parents.

Over and over studies have shown that the most vulnerable populations were steered to the most disadvantageous (to them) products, often with deliberate disregard for their ability to pay. This part of the housing problem was riddled with criminality.

What is missing in your post is that the federal government, primarily during the Clinton administration, promoted the notion that everyone should own a home. The government used Freddie and Fannie to backstop shaky mortgages and provided incentive for banks and mortgage companies to make the loans with federal support. Owning a home is a earned priviledge, not a right. And many people used the system to get mortgages that they could not really afford....they bet on the "come" and got burned! The hedge funds took advantage of the loans and the SEC and other agencies turned a blind eye when the problem expanded. Maybe they spent too much time watching porn instead of doing their jobs! Of course, you would expect that high credit risk customers will be more likely to fail than responsible customers. Buying a home is an investment and needs to have the same scrutiny that any big investment would have. No real surprise in this report.

I think in many cases, the information asymmetry revolved around one side of the transaction believing that the statement "and in a couple of years, after you've made the payments, you can refinance to a standard fixed rate mortgage" was true, with those on the other side of the transaction knowing that it was not true (or not caring that it probably wasn't true, since they were going to collect their fees and package the thing for resale anyway).

unscrupulous mortgage brokers deliberately peddled the most toxic products to the people who understood them the least.

Word.

Some sensible financial regulations that would criminalize selling subprime mortgages to those who qualified for better mortgages would be a good start. Having mortgage brokers fees dependent on whether or not the mortgages they wrote didn't go into foreclosure would also help.

For many lenders the Option ARM was the default selection. Borrowers not only had to know about fixed rate mortgages, they had to fight to get a fixed rate mortgage.

The default for most Americans should be a 15 or 30 year fixed rate. Balloon payments and non-doc loans should obviously be illegal. If a borrower can't qualify for the payment on a 15 or 30 year fixed mortgage, then he or she probably would be better off waiting. One way to fix this is to force the lenders to hold onto larger chunks of the loans that they originate.

I can't remember where I read this, but somewhere it was pointed out that Texas, which has an extremely low foreclosure rate, is also notable for having extremely strict regulations on lenders. It is more or less illegal for lenders to refinance a home in ways that deplete the owner's equity, so you don't have door-to-door salesmen engaging in predatory lending.

I have to agree with JPRS-- 15 to 30 year fixed rate mortgages with no pre-payment penalties should be the default. One of the reasons for this is that we simply have to accept that there exist a large number of people in the country who simply don't have the mathematical skills to understand mortgages or the time to develop those skills. The solution is to regulate "mass market" products so that everyone knows exactly what they're going to get.

However, Option ARMs, balloon mortgages and others have their place. The tradeoff should be that the bank should not be able to sell or securitize these loans and should take responsibility for them.

"What seems to be happening here is not that folks who are financially illiterate choose worse mortgages so much as folks who are financially illiterate make more financial mistakes once they have their mortgages. "

While I agree that some people were given predatory mortagages - this study seems to say that even smart people that got the same loans ended up ok. It seems to me that the conclusion is that people that are bad at math are more likley to default. Two people getthe same ARM loan - one is good at math and one isn't. The gut that is good at math is more likely to pay, the guy bad at math is more likely not to pay. This would seem not to support predetory lending b/c the smart guy got the same loan and made the payments. This could lead to a math test for your credit score! Or they could factor in your SAT score for credit purposes!

Holla26, I would argue that we have to accept that predatory practices will inevitably catch the mathematically illiterate in their net which ends up with the potential to harm the rest of the economy as well as neighborhoods and society. We should allow the mathematically literate to go seek out ARMs or other exotic mortgage instruments on their own.

I would rather that the mathematically literate pay a little more by using "standard" mortgages if they lack of motivation to seek out exotic instruments than face a default-cascade because aggressive sales practices and securitization caught the financially illiterate in their net.

By analogy, people with fire prevention and firefighting abilities might be better at surviving life in a house not build up to the proper safety codes, but we still enforce safety codes for everyone because failures by one person can affect everyone else.

Page 31: "We surveyed individuals between 1 and 2 years after their mortgages had been originated, and many subprime mortgages defaults happen within two years of origination. Thus, our results do not completely rule out the possibility that limitations in financial literacy led to unfavorable mortgage terms or contracts that contribute to unfavorable outcomes."

i.e. "maybe we should have highlighted this significant qualification in our abstract, but we didn't because we want people to read our paper".

The segment Ezra quoted said that the study result was "not driven by ... the characteristics of the mortgage contracts." In other words, it doesn't matter whether they had ARMs or fixed-rate mortgages. The terms of the mortgage don't matter. The study is saying that people who lack the math skills to manage their money are more likely to fail under any financial conditions.

constans -
"I would rather that the mathematically literate pay a little more by using "standard" mortgages "

Is that like saying everyone with C's and A's should be given B's so it's fair?

"By analogy, people with fire prevention and firefighting abilities might be better at surviving life in a house not build up to the proper safety codes, but we still enforce safety codes for everyone because failures by one person can affect everyone else."

good analogy but life will always allow for advantages - even though there are codes for everyone - some will still be better firefighters and be better prepared.

I think the best part of reading this paper is noticing that you've gone from reading the small-child arithmetic quiz questions that they asked people back to the research paper statistical analysis ("heteroscedasticity"). Sort of a mental math-shear effect. The other interesting thing is that lots of people apparently grew up and borrowed large amounts of money to buy houses without being able to pass a small child arithmetic quiz.